Archive for November, 2006

2006-11-10 :: Looking Toward 2007

Friday, November 10th, 2006

As we are getting closer to year-end, I thought it might be interesting to examine what we can expect for 2007.

The national mood, I think, will shift from a navel gazing examination of everything that is wrong with the current moment to a hopeful view of life getting better.  Change can be painful at times, but it can also be cathartic, providing a fresh perspective on things.  My gut feeling, with all of the fairly conservative democrats that were elected, we have the opportunity to accomplish some things that people with mainstream views will appreciate.  That should convert itself into a more favorable national mood that in turn increases optimism for the future. 

Optimism for the future has in past years led to increased P/E ratios, and (as long as earnings continue to grow) rising  stock prices.    There is currently $5 trillion in cash sitting in money market funds and bank accounts that at one time was in the stock market.  As optimism increases, and as baby boomers turn 50 in greater numbers than in any previous year, you should see that cash go to work in buying stocks.

What sectors will see the greatest cash influx and the biggest price moves in their stocks?  My analysis says that it will likely be the consumer electronics stocks (piggy backing on some big trends – HDTV’s below $1,000; the mass downloading of the new Windows product, Vista; the continued move toward Apple entertainment products with the introduction of the iPhone, and filling the 500,000 order backlog for iMac’s) and a return of the commodity stocks (metals and energy, although you’ll likely see that the Asian producers will outperform the US and European producers over the coming years) and cyclical stocks as the Fed begins to reduce interest rates.  We will also likely see moves toward alternative energy producers (since that was a near universal pledge during the campaigns) although I’m not sure yet whether it will be an Ethanol play, a nuclear energy play, or a technology play that wins out here. 

Conventional wisdom says that health care companies will be more heavily scrtinized and be pushed toward a nationalized medicine / medicare type program, now that a new party is in power.  This has sold off the health care stocks since Tuesday, providing a good buy-in point for companies with high growth rates and profit margins.  We are beginning to take advantage of this (likely short-term) mis-pricing.  The conservative/moderate democrats that gained office came to power with the help of a lot of moderates and conservative of both parties, and nationalized health care is not something that they favor.  Fixing the inequities of the current system will be the priority, not scrapping it and starting over.

Historically, as the Fed begins to ease rates, financial institutions’ stock performance is one of the market leaders.  This congress will likely (and correctly) begin to examine hedge funds and derivatives.  This could have a negative impact on some of the money center banks and investment houses, but small and regional banks should flourish.

And, most importantly for the future of investment portfolios, 2006 was the year that the countries in the Emerging Markets had a collective GDP greater than those of the developed markets.   The world’s financial powerbase has shifted to these “poor” countries whose savings rates are so significantly higher than those in the developed countries that they are now the net capital suppliers (equity and debt financing) to the West.  This shift will increase the move of the citizens of the emerging economies to the middle class and increase the need for energy, alternative energy, metals, water, and food. 

So, in coming posts, you will see these ideas begin to take shape in the form of investments.  We’ve already begun to add certain companies to the list in the consumer electronics area, ahead of the Christmas season:  Digital River, Apple (we have a good til canceled buy that has not yet filled), Silicon Motion, Silicon Image, and CREE.  We’ve also started to build positions in Imunocor to take advantage of the health care mispricing opportunity.  In the financial sector, we’ve increased our exposure to Alliance-Bernstein and small reginal banks Carolina Bank Holdings and City Bank (Seattle).

Have a great weekend and get excited as 2007 should be a big year for investors!


2006-11-02 :: Bear Market Analysis

Thursday, November 2nd, 2006

I’ve cut/paste an interesting analysis from Doug Kass, a frequent contributor to CNBC and The Street.  He is a tried and true bear, so I thought you all might find his analysis compelling.  The contrarian in me says that with all of the small investors now jumping in to buy the large caps / index-related stocks, it is time to get cautious.

We’ve been tightening stops under some of the stocks that have had nice runs over the last couple of months, so if the market does pull back significantly, we’ll automatically generate cash.  Stop Losses are not an exact science as the price you enter the stop at is unlikely to be the place where you sell; generally its lower (sometimes a lot lower), since all the stop does is authorize the brokerage to sell the stock once the price drops to or below your price.  If the stock opens down 5% due to some unexpected news, you will sell at that 5% down point instead of at your stop loss price.  The good news is that it gets you out of the stock before it drops to a 10% loss.  We’ve had a few hit already and have been reinvesting some of the cash and leaving some in money market for future purchases if/when the market does pull back.

Anyway, here are Doug Kass’ thoughts on the coming bear market (his thesis):

Making the Bear Case

A virtual cornucopia of optimism based on the resumption of another Goldilocks has investors partying almost like it was 1999. As Barron’s Alan Abelson remarked several weeks ago, the market seems like investors are at a perpetual happy hour. Complacency has become profuse, while fear and doubt have nearly been driven from Wall Street. To state the obvious, a sharp decrease in the yield on intermediate-term and long-term bonds coupled with a substantial reduction in the price of energy products has trumped increased evidence that the rate of economic growth is decelerating while inflationary pressures stubbornly persist. Despite the bears’ incessant protestations, equities have now risen in nine of the first 10 months of the year and, as of this date, have climbed by more than 11% (including dividends).

The Bears’ Burden of Proof

For now, good and bad news is good news for equities, and the burden of proof lies squarely with those who have had an ursine view. The market’s recent treatment of Wal-Mart’s (WMT) same-store-sales weakness as a one-off is symptomatic of an equity market that is interpreting even the most disturbing data points as a net positive in what I interpret as a copious complacency. It might sound arrogant (like I’m talking my short-selling book), but I believe that the current rally is being propelled more by money than logic, and more by emotion (and performance anxiety) than fundamentals. Unlike CNBC’s Larry Kudlow, who says the economy is “the greatest story never told,” I say that the equity market is “the greatest story ever sold.” Stated simply, the future of the economy does not look like Goldilocks to me. My baseline economic view is for a lumpy and uneven period of growth. Not a recession, but what I call blahflation (blah growth and stubbornly high inflation), a setting corporate managers and investment managers will find hard to navigate. The benefits of a material decline in energy prices have propped up consumer spending, which was beginning to waver in the spring. Nevertheless, in light of a number of variables (not the least of which are geopolitical in nature), confidence that energy prices will remain subdued is what we all hope for. But in all likelihood, the price of energy products will remain volatile, with an upward bias. My economic concerns continue to be focused on my expectations of a protracted housing downturn, the vulnerability of the consumer, stubbornly high inflation and the prospects for eroding corporate profit margins and disappointing earnings in 2007-08.

A Hard Landing for Housing

Generational lows in interest rates and unprecedented speculative activity formed the basis for housing’s disproportionate role in economic growth this decade.

  • The real estate industry has been responsible for 40% of the job growth since 2001.

  • The rise in home prices has provided for 70% of the increase in household net worth since 2001.

  • The increase in consumer spending and real estate construction spending has contributed to 90% of the growth in GDP since 2001.

Because of housing’s extraordinary economic contribution, the downturn that is being experienced will have much broader ramifications on our economy than generally expected. It will be particularly hard felt in California, the epicenter of the egregious use of creative mortgage vehicles. From a national perspective, the loss of construction, mortgage-lending and real estate jobs will weigh significantly on the next six months of jobs reports. At the height of the housing market, consumers were borrowing almost 10% of their incomes as mortgage equity withdrawals. This cash-out refinancing added 1%-1.5% to GDP per year. Such refinancing has dropped in half and, despite lower interest rates, is in free fall. Only a year into the downturn, home prices are experiencing unprecedented sharp declines, particularly in the previously strong coastal markets. Many argue that regional influences are skewing these home-price drops. The price declines are being understated, as they do not incorporate builder and broker incentives: The next several months will be an important tell.

Rumors of Slowing Inflation Are Off Mark

Most market participants believe that inflation is moderating and that the Federal Reserve will soon start cutting rates, perhaps as early as the first quarter of next year. It is not clear that this will be the case. Dallas Fed President Richard Fisher’s September speech confirmed the inflationary concerns echoed by the Federal Reserve Bank of San Francisco Janet Yellin, whose comments also were ignored by market participants. At that time, Yellin announced that while she voted to keep interest rates steady, she was prepared to tighten further if inflationary pressures intensified. The most revealing part of Fisher’s speech was his view that the Dallas Fed (and the Cleveland Fed) have begun to look at a new measure of inflation called the Trimmed Mean PCE Inflation Rate, which challenges the old way the Fed calculates inflation. When I first heard this term, I googled it and found a working paper written by a Dallas Fed researcher, James Dolmas. (A special thanks goes to John Mauldin for aggregating this study and the speeches of the Fed heads.) Dolmas explains that because food and energy have real meaning in a real world, he includes those factors and arrives at a more meaningful inflation gauge called a trimmed mean, by taking out outlier reports (discarding a certain amount of the lowest and highest values and then computing the mean of those that remain). Of course, the question is what does the Dallas Fed’s new measure of inflation indicate? The answer is a huge difference! According to Fisher, the trimmed core PCE inflation rate was 3.2% in July (compared to the 1.7% rate that the Fed uses for core PCE). This, of course, is well above the Fed’s comfort zone.

What Does the Future Hold for Inflation?

While the equity market focuses on the salutary effect of lower energy prices, grains are soaring and, importantly, the rate of growth in unit labor costs continues to accelerate to levels not seen in years. So are the nonenergy industrial materials index, tuition payments, insurance premiums and a host of other expenses rising, which will serve to keep real median incomes from advancing? (That’s a vulnerable situation given the absence of personal savings.) If the short term contains inflationary risks that are being ignored by most investors, the longer term seems even more problematic. Consider Federal Reserve Chairman Ben Bernanke’s recent speech regarding the threats of the coming crisis in Social Security and Medicare funding and Congress’ disregard for this issue. To summarize, he stated that if demographic issues surrounding Social Security and Medicare are not addressed, our population will have 14% less potential for consumption within the next 25 years. So far, Bernanke’s longer-term public-policy concerns have fallen on deaf ears in Congress, and the remarks made by three other Fed governors regarding inflationary pressures have fallen on deaf ears in the investment community.

The Prospect for Lower Profit Margins

Since 1950, there have been eight incidents of profit margin peaks: the third quarter of 1997; the fourth quarter of 1988; the first quarter of 1984; the fourth quarter of 1978; the fourth quarter of 1965; the fourth quarter of 1955; the first quarter of 1953 and the fourth quarter of 1950. Today’s profit margins (as measured by pretax profit relative to nominal GDP) stand at about 13% — that’s at the highest level since 1953! (Over the last half-decade, on average, margins peak at around 10.9% before contracting to 6.6% during economic slowdowns one year later.) In contrast to the current level of 13% margins, pretax corporate profit margins peaked at 7.4%, 7.8% and 9.8% in the three previous economic cycles. According to Merrill Lynch, in six of those eight occurrences of GDP slowdowns and peaking margins, corporate profits declined. On average, earnings growth went from +29% to -8% in the next year! So if history is a precedent — and given that so many signs suggest that top-line sales growth will be moderating and inflationary pressures stubbornly high — the bottoms-up forecast for 12%-13% earnings growth in 2007 appears to be a pipe dream.

A Dose of Reality

The tailwind of a world fueled by excessive stimuli is being replaced by these headwinds (and others), bolstering my outlook of a lumpy and uneven period of economic growth. For now, to paraphrase The Mamas and The Papas’ song Creeque Alley, everyone’s getting fat except Papa Kass. But, as night follows day, today’s chorus of booyahs will be replaced by a dose of reality in the months to come.

More later!


2006-11-01 :: Energy Trust Changes

Wednesday, November 1st, 2006

Below is an article from Change Wave Investing discussing the surprise move by the Canadian Government to propose changing the income trust rules that many Canadian companies have adopted as their corporate structure.  This has been a great income investment for clients looking for levels of income that they can’t get from bonds.  There has been a lot written about this situation today, since it impacts so many Americans (particularly retired ones living from the income of their investment portfolios), but I thought this analysis was the best.


Well, it was quite a day for us energy trust holders.

Overnight, the Canadian government panicked over the conversion of “too many” operating businesses into business trusts that distribute the bulk of their income to shareholders. And in their panic they have thrown energy trusts into the same boat as a garbage company or Yellow Pages supplier.

This notion that energy trusts are like operating service businesses is absurd, and ultimately, I think cooler heads will prevail. As I write this, just about every CEO from the major Canadian energy trusts is winging his or her way to Ottawa to start the negotiations.

But this is NOT the law of the land yet — it’s just a first salvo. And even if this proposal stands, we have a four-year phase-in exemption for existing trusts like the ones we recommend.

The best way to view this proposal is as an emergency “time out” for Canadian Bell (BCE) and another $100 billion of business assets that have filed to convert to trust status. Revenue Canada wants to stop what it perceives to be an unintended consequence of their business trust rule change that was made many years back. This is NOT a shot at the energy trusts.

So, take a deep breath — now is not the time to panic. As the market stands now, we have a 10%-15% correction in the trusts, and that is fair if this proposal lives as-is.

Levying the taxable part of an energy trust distribution at 41% (versus the 15% withholding on the taxable portion of dividend) at first blush seems to be a deal killer. Remember the last time a proposal like this was tossed out by the Canadians? It got whacked like an extra on “The Sopranos.”

The energy trust industry can make a solid case to be carved out of the “business trust” group that the government is really going after. All the negative rhetoric on business trusts concerns big corporations that have proposed converting $70 billion -$150 billion (Canadian) into business trusts SOLEY for the better tax treatment.

The big worries up north are that:

* the tax take from corporations will drop below 30% of all taxes paid (i.e., where it is now)
* there will be no money left for R&D in companies that pay out so much of their earnings in dividends

Real estate investment trusts (REITs) maintain a separate status in this proposal — why not energy trusts?

It doesn’t make sense for Canadians to tax corporate dividends of operating, non-energy enterprises differently than trusts, unless the goal is to improve the after-tax income of retired Canadians. And I don’t think that’s the intent.


Energy trusts are not in the game of costing Canadians much in the way of taxes, for the most part.

Yes, less corporate taxes are paid if you own long-lived energy assets in a trust rather than in a regular tax-paying corporation, but only slightly when you consider how many additional assets are under management and production by energy trusts.

So, fewer taxes are paid to the extent that a Canadian energy trust is owned by Americans and other foreigners, but this doesn’t happen in a vacuum. What about the higher rates of income tax and income generated by the industry in Canada, and the extra taxes paid by lawyers, accountants, energy services companies, etc. employed by these trusts?

We’re talking literally billions of extra income tax dollars CREATED by the energy trust business. Nowhere does this calculation come forth in the proposed new laws.

And what about the extra $5 BILLION – $8 BILLION in capex invested each year by energy trusts that goes mostly to the Canadian economy? For crying out loud, doesn’t anybody read their 10-Qs?

If these laws go into effect, much of that money used for capex spending goes back to goosing monthly dividends. Don’t these jokers understand the energy trust business model?

Energy trusts are a new business model for the capital-intensive energy business — NOT a corporate tax dodge.

They serve an important role in Canada and North America by creating a capital structure that makes it economical to drill non-exploration production wells in marginal but long-lived energy assets that would not be feasible for E&P companies.

Mixing energy trusts with operating business enterprise trusts does not make sense. Maybe this is the time to change THAT part of the Canadian tax code.


Let’s take a look at the foreign tax credits.

The change, if approved, would negatively impact dividends to non-residents by 26.5%, according to BMO Capital Markets. But that does not take into account the tax CREDITS that no one is talking about. That’s because most of the people doing the talking are Canadian.

Our foreign dividend tax credit with an 85% exclusion for foreign taxable dividends still makes a big difference in owning energy trusts. A rise in the withholding would OFFSET the tax credit — every dollar withheld would be converted to a tax credit that could be applied against U.S. taxes. So U.S. shareholders would not be taking a 26.5% decrease in after-tax or after-tax-credit distributions.

(Note: The dollar-for-dollar foreign tax credit is awesome, but your foreign tax credit cannot exceed your U.S. tax liability multiplied by a percentage. The percentage is your total foreign-source income divided by your total worldwide income. You must figure the allowable amount by various categories of income. Examples of these income categories include investment income and wages.)

However, when we figure after-tax credit returns, energy trusts are still very attractive versus other income vehicles.

If this proposal becomes law, energy trusts will ramp up their payout percentage of income to partially offset the decline in post-tax cash flow. This will reduce their ability to invest in the conversion of probable reserves to proven, which will start to affect energy trusts AFTER 2011, not before.

When you figure in after-tax credit cash of cash returns, one thing stands out: It will be better to own these trusts as an American than a Canadian. Hmm … was that really their intent?

This quote from BMO analyst Gordon Tait in a MarketWatch report today sums it up nicely: “We would point out to the minister that a potential 10% correction in the capitalization of the trust market equates to an approximate $25 billion destruction of wealth. A $25 billion hammer to fix a $500 million to $800 million problem does not look like a very equitable solution.”

Another key issue is long-lived reserve asset prices.

Until today, energy trusts paid up to $18 a barrel for reserves versus $12 or so for the exploration and production companies. If energy trusts can’t raise more capital, it takes a buyer out of the market and lowers the value of long-lived reserves — just another factor that was overlooked in the initial discussion.

Bottom line: this is just the first volley in a showdown about these trusts in Canada. We’ll hold tight with our Canadian trusts until the picture becomes clearer.